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Absorption and marginal costing

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Absorption and marginal costing

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Introduction <ul><li>Before we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing </li></ul><ul><li>However, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing </li></ul>

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A company started its business in 2005. The following information Was available for January to March 2005 for the company that produced A single product: $ Selling price pre unit 100 Direct materials per unit 20 Direct Labour per unit 10 Fixed factory overhead per month 30000 Variable factory overhead per unit 5 Fixed selling overheads 1000 Variable selling overheads per unit 4 Budgeted activity was expected to be 1000 units each month Production and sales for each month were as follows: Jan Feb March Unit sold 1000 800 1100 Unit produced 1000 1300 900

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<ul><li>Required: </li></ul><ul><ul><li>Prepare absorption and marginal costing statements for the three months </li></ul></ul>

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Fixed manufacturing overhead are treated as period costs . It is believed that only the variable costs are relevant to decision-making. Fixed manufacturing overheads will be incurred regardless there is production or not Fixed manufacturing overheads are treated as product costing . It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads Treatment for fixed manufacturing overheads Marginal costing Absorption costing

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Lower value of closing stock that included the variable cost only High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock Value of closing stock Marginal costing Absorption costing

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If the production = Sales, AC profit = MC Profit If Production > Sales, AC profit > MC profit As some factory overhead will be deferred as product costs under the absorption costing If Production < Sales, AC profit < MC profit As the previously deferred factory overhead will be released and charged as cost of goods sold Reported profit Marginal costing Absorption costing

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<ul><li>Compliance with the generally accepted accounting principles </li></ul><ul><li>Importance of fixed overheads for production </li></ul><ul><li>Avoidance of fictitious profit or loss </li></ul><ul><ul><li>During the period of high sales, the production is small than the sales, a smaller number of fixed manufacturing overheads are charged and a higher net profit will be obtained under marginal costing </li></ul></ul><ul><ul><li>Absorption costing is better in avoiding the fluctuation of profit being reported in marginal costing </li></ul></ul>

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<ul><li>More relevance to decision-making </li></ul><ul><li>Avoidance of profit manipulation </li></ul><ul><ul><li>Marginal costing can avoid profit manipulation by adjusting the stock level </li></ul></ul><ul><li>Consideration given to fixed cost </li></ul><ul><ul><li>In fact, marginal costing does not ignore fixed costs in setting the selling price. On the contrary, it provides useful information for break-even analysis that indicates whether fixed costs can be converted with the change in sales volume </li></ul></ul>

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Definition <ul><li>Breakeven analysis is also known as cost-volume profit analysis </li></ul><ul><li>Breakeven analysis is the study of the relationship between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of activity </li></ul>

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Application <ul><li>Breakeven analysis can be used to determine a company’s breakeven point (BEP) </li></ul><ul><li>Breakeven point is a level of activity at which the total revenue is equal to the total costs </li></ul><ul><li>At this level, the company makes no profit </li></ul>

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Assumption of breakeven point analysis <ul><li>Relevant range </li></ul><ul><ul><li>The relevant range is the range of an activity over which the fixed cost will remain fixed in total and the variable cost per unit will remain constant </li></ul></ul><ul><li>Fixed cost </li></ul><ul><ul><li>Total fixed cost are assumed to be constant in total </li></ul></ul><ul><li>Variable cost </li></ul><ul><ul><li>Total variable cost will increase with increasing number of units produced </li></ul></ul>

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<ul><li>Sales revenue </li></ul><ul><ul><li>The total revenue will increase with the increasing number of units produced </li></ul></ul>

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Margin of safety <ul><li>Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss. </li></ul><ul><li>This can be expressed as a number of units or a percentage of sales </li></ul>

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Example <ul><li>The breakeven sales level is at 5000 units. The company sets the target profit at $18000 and the budget sales level at 7000 units </li></ul><ul><li>Required: </li></ul><ul><li>Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue </li></ul>

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Limitations of breakeven analysis <ul><li>Breakeven analysis assumes that fixed cost, variable costs and sales revenue behave in linear manner. However, some overhead costs may be stepped in nature. The straight sales revenue line and total cost line tent to curve beyond certain level of production </li></ul>

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<ul><li>It is assumed that all production is sold. The breakeven chart does not take the changes in stock level into account </li></ul><ul><li>Breakeven analysis can provide information for small and relatively simple companies that produce same product. It is not useful for the companies producing multiple products </li></ul>